A Taxing Time for Japan

The government is considering a 3% hike in the consumption tax to pay for reconstruction. But will it backfire?

By James Pach for The Diplomat

April 21, 2011

The debate has begun in Japan on how to fund the reconstruction and recovery from the March 11 disaster. With public debt levels at worrying highs, the Japanese government is loath to rely on additional bond issues and has raised the possibility of a hike in the sales tax, known locally as the consumption tax.

The Cabinet Office has estimated that the bill for reconstruction could be as high as $300 billion, not counting the economic impact of lost production. To put that in context, Japan’s total tax take for fiscal 2010 was an estimated $450 billion. The government struggles to raise $300 billion in a typical year through corporate and individual incomes tax combined, so using these taxes to pay for reconstruction would require very substantial rate hikes, fatal for the struggling economy.

In contrast, the consumption tax generates an average of $120 billion in revenue each year with the current rate of just 5 percent, very low by international standards. Economists reckon that each percentage point increase in the tax would offer an additional $30 billion in revenue. The government is considering a 3 percent hike, which it estimates could produce nearly $275 billion over 3 years, paying for much of the cost of rebuilding the disaster-struck regions.

Even before the crisis, the ruling Democratic Party of Japan had raised the possibility of a future hike in the consumption tax as a means of reining in the government’s runaway debt reliance. The International Monetary Fund has certainly been urging Japan to act.

But the consumption tax has been unpopular with the Japanese public since it was first introduced on April 1, 1989, originally as a means to fund programs for the elderly. Anger at the new tax combined with a scandal to force then Prime Minister Noboru Takeshita from power later the same year. A subsequent premier, Ryutaro Hashimoto also lost his job in 1998, after he was blamed for a sharp recession that followed in the wake of an increase in the tax from 3 percent to 5 percent in 1997. Last year, the incumbent Prime Minister Naoto Kan suffered a thumping at the Upper House elections for merely mentioning the possibility of a future hike. His government has never recovered.

This time might be different, however, as recent polls suggest that the public is willing to accept a tax increase to help Japan recover from the disaster. Still, the opposition Liberal Democratic Party is opposed to the idea of a rate hike, on the grounds that disaster victims would also have to pay the higher tax. As usual, it hasn’t been forthcoming with a better idea.

Even without the disaster, a consumption tax increase was probably always going to be part of fiscal reform in Japan. The major problem in Japan isn’t so much runaway fiscal spending, but falling tax revenues. As we’ve seen, consumption tax is probably the only tax that can be raised without catastrophic results. But the 1997/98 experience suggests that in the short term at least, the current skittishness of Japanese consumers may make a hike counterproductive, producing a recession that could actually diminish revenues.

At some point fairly soon, Japan is going to have to be fiscally innovative, and adopt a more unorthodox approach. Additional taxes on income and spending are never going to be very effective in a country whose default state is contraction (for demographic reasons). Japanese companies and individuals are sitting on savings that far outweigh even the gross public debt. These savings are the legacy of two decades of private-sector inactivity—the reason for Japan’s malaise. As the spender of last resort, the Japanese government has been borrowing against the savings, through the financial institutions that buy its bonds. At some point it is going to have to devise a way to tax them, both to raise new revenues and to encourage money to find more productive uses.

More on this soon.

James Pach is the publisher of The Diplomat and the founder of Trans-Asia Inc., a Tokyo-based translation and investor relations company.

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